Why we need to challenge traditional perspectives on working capital. By John Mardle, working capital facilitator, Develin and Partners.
Working capital is at the top of every CFO and finance director agenda according to the latest research from Europe CFO, JP Morgan and Global Treasury News. Yet this area enjoyed ‘Cinderella’ status for much of the boom times. What has changed?
Firstly credit is hard to come by for most organisations and if available it is increasingly made expensive by fees, penalties for not hitting targets and very tight terms of repayment.
Secondly working capital has traditionally focused on metrics like days sales outstanding (DSO), days purchases outstanding (DPO) and days inventory outstanding (DIO). But today these metrics need to be developed by enhanced metrics (or as we call them drivers) that identify the real issues as to why DSO has increased or DPO has decreased.
Finally working capital needs robust and consistent financial commentary. Investors, stakeholders and employees rely on such information to appreciate the cash conversion cycle (CCC) and whether there are issues that need to be addressed in future cash flows. Regulatory bodies like the UK’s Financial Services Authority and the Auditing Practices Board are also keen to ensure this area is highlighted in all future reporting.
We need to challenge some traditional perspectives
By definition working capital equals current assets minus current liabilities.
Working capital is useful to show the operating liquidity of a company and how the company manages its business but traditional measures could be giving false signals.
The working capital cash conversion cycle is traditionally a computation that is augmented by the use of DSO when describing how long it takes an organisation to collect its invoiced debts from its customers; by DPO when analysing how late suppliers are being paid; and by DIO when appreciating how quickly stock is turned into cash. However in today’s service driven economy one has to look more closely at inventory as work in progress can be particularly difficult to ascertain both in value and in ‘timing’.
This is because the service and construction orientated sectors have the additional complication of ‘time’ ascertainment either via timesheets, work logs or allocated costs of labour that are prone to many types of errors. These could cause sales and purchase invoices to be rejected, for example, and therefore valuations of work in progress can become very subjective.
When we look at the assets of the balance sheet, accounts receivables is listed under assets but when you start thinking about working capital it should actually be under the liabilities section.
This is because the amount of accounts receivables is really just an interest free loan to the customer. The company has not received the cash for the bills. It is only when accounts receivables decreases that cash flow increases. This is what the term ‘changes in working capital’ refers to. The working capital change on the balance sheet impacts the cash flow statement.
Inventory is another major component of working capital and can also be considered to be a liability while accounts payable will add to positive cash flow because it’s money that you owe but haven’t paid yet. So it’s like an interest free loan that increases your cash flow.
Working capital also has its own set of disadvantages
Current assets and liabilities are fairly easy to manipulate and depending on the accounting method, the amount will vary by considerable amounts. For example, a company using the last in first out (LIFO) method to value inventory will have a much lower inventory value compared to a company that uses the first in first out (FIFO) method. The two companies could have exactly the same set of products in their warehouses but - just depending on whether they use conservative or aggressive accounting - it will make big differences.
Working capital can also vary drastically year to year which could provide an inaccurate picture of the business as well as affect the projected growth rate.
But there is no right or wrong. It just depends on how you view a business and investment.
Supply chain management
Major organisations like Rolls Royce are addressing many of the issues of cash flow by imposing a supply chain management approach. This ensures that suppliers are firstly vetted to ensure they comply with the organisation’s supply requirements regarding quality, price and other process type criteria. Certain organisations are also applying financial constraints to move payment to suppliers from 60 days to 75 days from the end of the week that the supplier’s invoice is processed.
This is causing working capital issues for smaller suppliers. Unless rigorously monitored to ensure that these smaller suppliers are not detrimentally impacted, it could significantly affect the supply chain such that the major organisation might find itself without vital supplies, which in turn would impact its ability to satisfy its own customers.
Other organisations are applying a Demand Chain Management approach which ensures there is a customer demand for a product or service before the supply chain management system is applied.
Streamlining working capital processes
At the heart of this whole issue is the fact that treasurers, accountants, credit agencies and financial institutions alike, need to be able to predict cash flow for at least the next 12 months and strive to ensure it is robust and reliable. However as the last 12 months has shown the world’s economy is at risk should organisations rely upon credit rating agencies that take only the basic working capital fundamentals into account.
On a practical and quite basic level, streamlining all internal working capital processes would, I suggest, generate substantial cost savings. This streamlining could be as simple as eliminating ‘noise’ from daily activities like posting sale and purchase invoices daily and testing IT systems to ensure they are posting amounts of say hours/cash in a robust and timely manner.
There is an opportunity to rapidly but rationally assess the way your organisation works in the area of working capital optimisation and cash flow forecasting; an opportunity to ensure that core activities and processes are efficient and fit for purpose. Organisations that respond now in this downturn, will be the best placed to take full advantage of the inevitable cyclical change.
Links
Working capital optimisation, a CIMA Mastercourse presented by John Mardle
CIMA resources - Managing cash flow
Managing in a downturn
Develin & Partners